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US fiscal stimulus may prove reckless

We are in uncharted waters. Prices for sovereign, corporate and high-yield bonds and equities are at, or near, record levels thanks to the ultra-low policy interest rates and the massive quantitative-easing programs of the G3 central banks (the US Federal Reserve, the European Central Bank and the Bank of Japan) over the past decade. But now two of those central banks are winding back. In response to the strengthening economic environment, the Federal Reserve is raising the cash rate and has commenced an automatic program to shrink its balance sheet while the European Central Bank has halved its asset-buying program.

Potential for reckless and explosive consequences

While the major central banks would like to engineer a ‘soft landing’ with gradual increases in interest rates, there is a material risk that they could be forced to tighten monetary policy faster than expected. In our view, the US administration’s tax cuts and recent budget measures have elevated the risks. The tax cuts and additional spending will make a fiscal injection into the US economy of nearly 2% of GDP per annum for the next two years. The timing of such a large fiscal stimulus at, or near, the top of an economic cycle when central banks are trying to exit the largest monetary expansion in modern history may prove to be reckless. The US unemployment rate at 4.1% is at a 17-year low and the US economy has added jobs over the past 88 months, which is the longest such consecutive stretch on record. While there appear to be powerful longer-term secular forces at work that are likely to result in low inflation over the longer term, there is a significant risk that the size and timing of the US fiscal stimulus could trigger a jump in US inflation, in particular from stronger wages growth, over the next year or two. This may be highly problematic for the Federal Reserve and complicate its efforts to engineer a gradual tightening with a soft landing. We cannot think of a similar combination of circumstances in modern history. The cocktail could be explosive. The best hope for investors is that either the US tax cuts and extra spending have limited effects on growth and inflation in coming years or the secular forces that have kept inflation low accelerate to offset any inflationary pressures from the fiscal stimulus.

Those hopes may well prevail, but the risks for investors over the next 12 months or so are asymmetrical to the downside. There is a meaningful probability that US inflation and wages growth will accelerate and the Federal Reserve will be forced to tighten monetary policy faster and by more than expected. On 27 February 2018 the Chairman of the Federal Reserve, Jerome Powell, responding to questions before Congress, suggested that they may need to tighten monetary policy more quickly when he said:

“At the December meeting, the median participant called for three rate increases in 2018. Since then, what we've seen is incoming data that suggests a strengthening in the economy and continuing strength in the labour market. We've seen some data that in my case will add some confidence to my view that inflation is moving up to target. We've also seen continued strength around the globe. And we've seen fiscal policy become more stimulative.”

Was it a 'canary in the coal mine'? 

If the Federal Reserve is forced to act more swiftly and forcefully than expected, it is reasonable to assume that US longer-term bond yields could jump meaningfully (above 4% compared with about 2.90% for the US 10-year Treasury bond today), which could trigger the biggest slump on world share markets since the global financial crisis. In our view, a 20% to 30% global stock market correction is within the range of outcomes in these circumstances.

What happened on 2 February 2018 may prove to be the ‘canary in the coal mine’ warning for investors. On that day, the US Department of Labor disclosed that average hourly earnings for private sector workers rose 2.9% in January from a year ago. This was the fastest rate of wages growth since 2009. The news triggered a jump in longer-term US bond yields to four-year highs and nearly a 10% correction in the US stock market.

In light of the risks, we have increased the defensiveness of the Global Equity portfolio. Over the past three months, we have increased the cash weighting of the portfolio to about 13.5% today. The increased cash weighting should enhance the defensive characteristics of our portfolio and act as a partial hedge against a potential market correction and higher interest rates in general.

It may turn out that we are wrong or premature to be so cautious. But we have no desire to remain at the party, nor be the last to leave, when we judge that risks are elevated. Investors in this environment could well take some sage advice from Warren Buffett in Berkshire Hathaway’s annual report for 2000:

“The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball … but they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”

 

Hamish Douglass is Chief Executive Officer and Chief Investment Officer at Magellan Asset Management, a sponsor of Cuffelinks. This article is general information and does not consider the circumstances of any investor.

 

7 Comments
Steve
March 08, 2018

A great article Hamish, thank you. The risks are building and it seems to me that the debt levels in Australia and in the US and other western countries is where the catalyst for a the tidal wave of problems will come. One risk I never seen discussed anywhere is the risk of an increase in the wholesale costs of funds to Aust banks and corporates. We constantly see two facts being restated - Australian official interest rates are on hold and US interest rates are on the rise. One would have thought if the US interest rates are going up and our dollar is falling, the banks cost of funds must be rising. The constant restatement that official interest rates are on hold is giving great comfort to those borrowing money in Australia; many of whom incorrectly equate official interest rates with mortgage rates. An interest rate increase by the banks in Oz will have to have a flow on effect for bad debts in the banking system, a crunch on consumer spending (till now a strong part of our economic story), as well as a reduction of demand and an increase in supply in the housing market. And just as we try to come to terms with the increasingly fragile state of the world economy we have Donald Trump lighting matches....

Frank Gomez
March 08, 2018

A contrarian view may be that the stimulus from the tax cuts will offset the risk of over-tightening monetary policy. I find it hard to believe that a 2% of GDP fiscal stimulus will cause inflation to go from being under-target to over-target when the growth of the Fed Balance Sheet of around 20% of GDP in recent years had little effect.

Any future administration/Congress is likely to wind back spending and tax concessions to start to bring the fiscal situation in the US back into balance so the 2% stimulus is unlikely to be permament and will eventually be wound back from future growth.

Frankie
March 05, 2018

Thanks for the warning, Hamish, but even if rates rose from the current 2.9% to say 4%, it's not earth-shattering compared with what we would once have considered normal. Might even give a few more investors a half-decent return on their cash and bonds and give them more money to spend. It's be different if we were talking 8-10%.

Steve
March 08, 2018

An increase from 2.9% to 4% represents a 138% increase in the cost of borrowed money - I think that's pretty significant.

Peter Smits
March 09, 2018

make that a 38% increase

Steve
March 09, 2018

I stand corrected :-)

Peter
March 12, 2018

Don't forget that the total amount of debt outstanding is significantly greater than when interest rates were at 4% in the past.

The last time the US 10 year rate was over 4% was back in July 2008. Back then the US federal government had about $9.5 Trillion of debt. That's an interest burden of about $380 Billion.

Currently the US federal government debt is about $21 Trillion. Therefore an interest rate of 4% would result in an interest burden of $840,000,000,000 p.a.!!

That's a huge difference.

 

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